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Annual Report – CMHC 2011

Dear readers, it’s happened again. The federal government is once again revising its rules on mortgage lenders. The new revisions are mostly a repeat of the changes they made back in January 2011, and that I reported on in a previous article. Maximum amortization periods were reduced by another 5 years, and maximum home equity loans were reduced by another 5% of the home value and apply only to new mortgages made after July 9, 2012.

“If the CMHC was made to stand on its own we see that it has consistently lost money for every year that financial data is available… it technically bankrupted itself over 10 years ago.”All of the criticisms I leveled at the original modifications still stand. I would like to make one additional point though and that is that if these changes were made with the intention of preventing a housing market crisis in Canada then the architects of this solution are sorely mistaken. Our housing market, like all other market bubbles, is dependent on what investors refer to as the Greater Fool Theory. In order to keep housing prices continually rising, demand growth must continually outpace the growth of supplies. By making things more difficult for prospective home buyers to finance their purchases, demand will necessarily soften and this throws a bucket of cold water on the now decade-long fantasy that owning a hugely expensive and depreciating asset is the road to true wealth.

At the epicenter of this entire trend is the Canadian Mortgage and Housing Corporation, a behemoth of a crown corporation. It performs the same function as the notorious US mortgage insurers Fannie Mae and Freddie Mac. Due to the sheer size of this organization, it behooves us as Canadians to keep a close eye on what the government is doing here because we are all ultimately on the hook for the CMHC’s debts and other obligations, should it not be able to handle them on its own. To that end I will be performing a regular analysis on their annual financial statements in order to report on their status and highlight what I believe are significant risks that they present to the average Canadian taxpayer.

Assets

The CMHC is an insurance company, and if you know how an insurance company works then you’ll be immediately troubled by what is going on with their assets. I’m talking about the $257 billion in mortgages that are on the books, representing 88% of their total assets. This is a problem because of the nature of this particular insurance company. Remember, the CMHC insures against mortgage defaults, providing lenders with a safety net that guarantees that they will never lose the principal they lent out. In the event of a severe downturn in the mortgage market, claims will start pouring in. The CMHC (nor any kind of insurance company) never possesses enough cash to cover all of these potential liabilities, they invest it. The problem here is that the CMHC has bought the very same assets they are insuring against. If the mortgage market collapses, so too will the value of the assets of the CMHC, making them extraordinarily difficult to liquidate in order to raise the cash necessary to pay out their claimants. It’s a catch-22 that spells potential disaster and deeply impairs their ability to actually insure against this particular type of credit risk. If we adjust the CMHC’s total insurance and assets to look at their net exposure and see how well their assets cover the amount of guarantees they’ve made we see that this ratio has grown tremendously, from a low of 3.85 in 2009 to slim 8.81 in 2011. This was the result of drastic actions taken by the CMHC shortly after the US housing bust in order to ensure that there was no panicked sell off here in Canada. These actions essentially boiled down to “guarantee everything in sight”, and the results speak for themselves.

Another point of concern is how quickly these guarantees are growing when compared to their assets. Total insurance-in-force is up 10.3% from last year, while total assets only grew 1.4%. This is simply unsustainable, particularly when 88 cents of every dollar of assets added is exposed to the same risks that the CMHC is insuring against.

Further compounding this problem is the razor-thin capital cushion that the firm is carrying. Assets to equity stand at an anemic 24:1, meaning a 4.1% loss on their assets will completely wipe out the firm’s capital. In reality, it will take even less than that due to the minimum capital requirements that all Canadian insurers must follow.

Liabilities

The CMHC’s liabilities present further problems with the fact that the company is highly indebted to both private and government creditors. You may have heard of the story that circulated this year exposing the fact that Canadian banks received $114 billion in government assistance during the collapse of the US housing market. The CMHC’s statements reveal that from 2007 to 2009 their borrowings from the government increased from $4.4 billion to a whopping $69.8 billion and have stayed at around that level ever since. Interest-bearing liabilities represent an incredible 96% of total liabilities. Interest expenses are also 74.3% of total expenditures and swallow up 63.3% of total revenues. This makes the CMHC incredibly sensitive to interest rate fluctuations. An 0.6% rise in the cost of servicing this debt would completely wipe out net income (the real picture is even worse, but more on that in the income section of this report).

Canada Mortgage Bonds*

(in millions of dollars)

Amount Maturing

Yield

2012

37,737

4.30%

2013

35,254

3.41%

2014

35,918

2.53%

2015

30,527

2.51%

2016

32,059

1.98%

2017-2021

27,878

3.36%

Total

199,373

3.04%

*In addition to these amounts is a further $2.2 billion borrowed at an average rate of 4.60%.

Borrowings from the Government of Canada*

(in millions of dollars)

Amount Maturing

Yield

2012

2,214

3.06%

2013

24,157

3.69%

2014

27,929

2.71%

2015

2,246

3.56%

2016

268

6.26%

2017-2021

1,705

6.77%

Thereafter

2,244

7.88%

Total

60,963

3.46%

*There is a further $6.6 billion in government borrowings at an average rate of 2.69%.

” There is a built-in assumption by the CMHC that a significant drop in the lifespan of the average Canadian is more likely than a rise in mortgage default rates.”Due to the fact that the CMHC generally borrows on 5-year terms, rising interest rates could have a material impact faster than expected. Not only do higher interest rates mean higher costs to service their debt, it will also impair the value of their mortgage portfolio resulting in further losses. This is likely a factor in the Bank of Canada’s decision to maintain the low interest rate environment in Canada. There is simply too much debt (both public and private) to allow rates to rise because of how addicted to debt the country has become. Furthermore, if private lenders aren’t willing to refinance the debt at these low rates and demand the return of their principal then the federal government must step in as guarantor of the CMHC’s debts. However, if investors aren’t willing to finance the CMHC anymore at the low rates they’re offering, they certainly won’t be willing to finance the government, who typically borrows at the lowest rates in the country. It will ultimately fall to the Bank of Canada to begin financing the CMHC’s debt (either directly, or through the Treasury) and this will cause a massive expansion in the monetary base of Canada, which presently stands at $67.4 billion and bring with it the risk of a substantially increased rate of inflation.

Income

As I’ve already mentioned, most of the CMHC’s revenues are swallowed up by interest expenses. What many people don’t know is that the CMHC has technically been on government welfare since at least the year 2000. They have received a total of $26.5 billion in federal assistance since the turn of the new millennium. If the CMHC was made to stand on its own we see that it has consistently lost money for every year that financial data is available. This, during the greatest bull market in housing the country has ever seen. In the year 2000, without assistance, the CMHC would have sustained a net loss of $1.6 billion. It only started the year with equity of $0.5 billion and so it technically bankrupted itself over 10 years ago. Adjusting for federal assistance we now see that interest expenses rise from $0.63 to $0.75 of every dollar brought in.

Insurance & Guarantees-in-Force

These items do not appear on the balance sheet but nonetheless should be looked at because they are the primary component of the CMHC’s operations. They represent a source of both revenue and liabilities, since they collect fees on the total amount but any portion of these could immediately be transferred to their liabilities as claims come in. Despite the revisions in mortgage rules implemented by the federal government, the CMHC is showing absolutely no signs of slowing down.

I find it odd that the government even bothers putting a constraint on the amount the CMHC can cover since it’s obvious that the limits will simply be raised any time they’re approached. The total amount covered now stands at $567 billion. Just as a point of reference, the national debt is $587 billion. Based on the provision for claims that the CMHC has set up, they only expect to pay out 0.18% of the total amount of risk they’ve taken on. This may be inadequate, as they also report in the financial statements that 0.4% of insured mortgages are already in arrears. Next stop is default, and a CMHC payout to the creditors.

Industry Comparison

It also helps to compare how the CMHC is doing to other similar companies to see whether or not their status is unusual. For this I have gathered up data from the property & casualty and life insurance industries (courtesy of the Office of the Superintendent of Financial Institutions), as well as data from Fannie Mae’s 2006 financial statements, which should provide a good picture of what it looked like right before it collapsed.

CMHC 2011

P&C 2011

Life 2011

FM 2006

Assets to Equity

24.14

3.48

14.71

20.33

Insurance to Equity

46.89

N/A

N/A

57.40

Interest Coverage

1.24

152.34

3.86

1.11

The interest coverage ratio (EBIT, divided by total interest expenses) is quite telling. The property and casualty figure is very healthy and the life insurance figure is within normal limits, but Fannie Mae is at positively rock-bottom levels with the CMHC right there with them. If a normal company had a ratio this low there would be alarm bells going off in all of the offices because they are struggling just to keep their heads above water. The CMHC is also extremely leveraged when looking at how much equity they have to support their assets. Granted, claims are much more likely to occur in the property & casualty insurance markets than they are in mortgage insurance however with life insurance it’s a different story. There is a built-in assumption by the CMHC that a significant drop in the lifespan of the average Canadian is more likely than a rise in mortgage default rates.

Conclusion

There is much to be concerned about with the financial health of the CMHC. The government is undertaking measures to stabilize the housing market but the evidence shows that they are not having the desired effect. Furthermore these measures only affect new mortgages, not existing ones. The CMHC remains highly susceptible to even a slight increase in the rate of mortgage defaults, or a rise in interest rates. With the federal government, and ultimately the Canadian taxpayer, on the hook for all of the CMHC’s liabilities we could soon find ourselves in an extremely difficult financial position.